LAW AND ECONOMICS

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LAW AND ECONOMICS

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LAW AND ECONOMICS

Sponsored by a Grant TÁMOP-4.1.2-08/2/A/KMR-2009-0041 Course Material Developed by Department of Economics,

Faculty of Social Sciences, Eötvös Loránd University Budapest (ELTE) Department of Economics, Eötvös Loránd University Budapest

Institute of Economics, Hungarian Academy of Sciences Balassi Kiadó, Budapest

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LAW AND ECONOMICS

Authors: Ákos Szalai, Károly Mike Supervised by Áron Horváth

June 2011

ELTE Faculty of Social Sciences, Department of Economics

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LAW AND ECONOMICS

Week 7

Performance of contract

Ákos Szalai, Károly Mike

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Structure of the week

I. Forms of remedies

II. Paradox of compensation

III. Liquidated damages, penalty clauses IV. Specific performance

V. Disgorgement

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Requirements

Today:

1. information 2. search

3. precision

4. risk allocation 5. performance 6. care

7. reliance

8. mitigation

9. modification

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I. Forms of remedies

• Damages

– Expectation damages – victim is compensated for the utility which he would have received from performance

– Cost – after compensation, victim’s utility is at the same level as before the contract (as if no contract) – incentive for efficient contracting (search, precision).

– Opportunity cost – victim’s utility is at the same level as if he contracted for the second best option.

– In a market: no differences among the three methods? Second best = first best (no rent).

• Liquidated damages: set by the contract

• Specific performance – see pacta sunt servanda

• Disgorgement: based not on loss of victim but profit of

breaching promisor

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II. Paradox of compensation

• Efficient performance, breach

– Judge Holmes: When is breach efficient?

• IF savings of breaching party > loss of promisee.

– Groves vs. John Wunder Co.

• Defendant contracted to restore the land after finishing mining – the original owner should receive the land back in the original condition

• No restoration.

• Cost of performance: $ 60.000,

• But (due to recession) maximum value (price)

of land is $ 12.000.

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II. Paradox of compensation

Optimal incentives for performance

• Efficiency: breach if and only if v < c

• Private incentives – without remedies: breach if

p < c

• With expectation damages:

d = v – p

• Private incentives: breach if and only if

v – p = d < c – p => v < c

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II. Paradox of compensation

• Efficient rule: expectation damages

– Ex post (at the time of performance/breach):

not Pareto-efficient, BUT Kaldor–Hicks efficient.

– Ex ante (at the time of contracting): Pareto- efficient.

• Harder rule (higher remedies): higher price;

• Softer rule (lower remedies): promisee willing to pay a higher price for a higher remedy

(Shavell)

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II. Paradox of compensation

Optimal incentives for care

• Now: only on the side of promisor

• Social optimum:

max B = (1 – P(x))(v – c) – x min P(x)(v – c)+ x

• Case of expectation damages: d = v max B = (1– P(x))(p – c)– P(x)(d – p) – x max p – c – (P(x)(v – c)+ x)

min P(x)(v – c)+ x

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II. Paradox of compensation

Optimal incentives for specific investment – reliance

• Reliance (trust): specific investment to increase the value of

performance – depends on trust, chance of performance (breach)

• Paradox of compensation: expectation damages („considering all reliance, investment) – supraoptimal reliance, investment, trust.

– Same as in the case of compensation for expropriation

• Example: Hadley v. Baxendale

– Repair is delayed, promisee (miller) suffers high loss – much higher than average (unforeseeable for promisor)

• Example: development of film unsuccessful (no option for repeating) – film about expedition in Himalayas

– Buyer did not say that the film had extra (unexpected, unforeseeable) value.

• Hadley rule: remedy = foreseeable loss…

– Goal: incentives for over-relying party

– Goal: incentive to disclose information (penalty default rule)!

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II. Paradox of compensation

Optimal incentives for specific investment – reliance!

• Private benefit

max B = v(r ) – p – r =>

v’(r) = 1

• Joint (social) benefit:

where g(c) is probability distribution of cost

• Optimal investment ( r * ): v’(r)G(v (r)) =1

(G(.) is cumulated probability distribution)

• Efficient rule:

• Private optimum:

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III. Liquidated damages

• US rule:

– Liquidated damages above ex ante expected loss (penalty) are not enforced.

– Liquidated damages below ex ante expected loss are enforced as they are.

• Hungarian rule:

– Liquidated damages above the real (ex post) loss are enforced (not reduced)

– Liquidated damages below real (ex post)

loss are increased by court up to the level

of loss.

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III. Liquidated damages

• Example: Gas industry: „Take or pay”

– Even if no delivery, price in contract must be paid –

– Not merely the difference between price and cost, or price in contract and second best buyer.

• Pros:

– High fixed cost

– Threat of underestimation of loss – uninsurable loss – Signaling – is it optimal?

– Both parties interested in excess capacity (built by the seller)

• Cons:

– Moral hazard (incentive for seller to make the buyer breach) – More difficult modification

– More suits

– Higher chance of bankruptcy – external effects

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IV. Specific performance

Value No remedy Specific performance

Remedy

A 9 2,5 1 1,5

B 11 1,5 1

C 12,5 1 1 1

SUM 3,5 3,5 3,5

Example:

• A: seller of the house – evaluation: 9 million

• B: original buyer – evaluation (willingness to pay): 11 million.

• Price in contract: 10,5 million.

• C: new buyer makes an offer to A – evaluation (willingness to pay) 12,5 million

• C: offers 11,5 million

• Remedy (compensation of B = expected gain ex ante) vs. specific performance

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IV. Specific performance

• Comparison

• Differences in distribution –

– Buyer’s payoff is higher if there is remedy.

• Minimizing costs:

– Contract (between A and B is a sunk cost), – Court’s cost of determining remedies

– Cost of administration to enforce specific performance.

• When?

– Assessment problem: false remedies; no substitution

– Favourable event – e.g. better offer; sale (vs. performance, service). Shavell: if third party is able to make an offer to the buyer as well (not only to the seller)?

– Cost of enforcement?

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V. Disgorgement

• Incentives: not only against inefficient breach

• When:

– Fiduciary relationship

• Hard to define explicitly the tasks of parties – Intentional (opportunistic) breach

• Utility directly from the loss (suffering) of the

victim (e.g. ex ante motivation for contracting

was to cause loss by breach)

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Practice

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Problem

• Tenant of an apartment does not pay the rent and the owner finds another tenant. Should the remedy be reduced by the amount of the rent paid by this second tenant?

(YES)

• Contract: 1.000 units of product promised. Buyer does not want to perform – seller sells them to another buyer.Should the remedy be reduced by the amount of the payment by the new buyer?

(NO)

• WHY?

• Amount of remedy = damages – depends on

• …elasticity of supply

– Apartment: inelastic

– Production: it is possible to produce more (for old and new buyers at the same time)

• But changes in marginal cost must be calculated.

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Problem

A CEO of a company takes the company’s money and invests it in an attractive financial asset.

This abuse of his position is detected and he must pay damages.

How much damages should he pay?

a) Damages equal to the foregone benefit of the company during the same period (foregone rate of return)?

b) Damages equal to the benefit the manager

obtained from the alternative investment

(i.e. disgorgement of benefit)?

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Solution

• Basic problem: Disgorgement

• When is it efficient?

• Problems of assessing the loss?

• Explicitness of management contract?

• „Preventing efficient breach” – what does it mean here?

– No investment for higher return… OR

– No investment for higher return in the NAME

OF COMPANY?

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